Finding the existence of an “implied agreement” whereby the decedent was to retain the possession and enjoyment of, and the right to income from, property transferred to a family limited partnership (FLP), the Tax Court has held that the FLP assets were includible in the estate pursuant to §2036(a). Estate of Reichardt et al. v. CIR, 114 T.C. No. 9, (2000).

[The decedent, after being diagnosed with terminal illness, formed a revocable living trust and an FLP in 1993, and shortly thereafter transferred nearly all partnership interests to his children. He then transferred all of his property (except for his car and a small amount of cash), and deeded real property of his deceased wife’s estate over which he held a general power, into the trust, and then from the trust into the FLP. The decedent continued to live in the residence which had been transferred to the partnership, withdrew funds from the partnership bank account, and continued to manage real estate and investment accounts of the partnership.]

The Court first determined, based upon the “facts and circumstances surrounding the transfer and subsequent use of the property” that there was an implied agreement that the decedent would retain the present economic benefits of the property, even if the retained right were not enforceable at law. In attempting to bear its burden of proof which the Court termed “especially onerous for transactions involving family members,” the estate argued, inter alia, that the FLP was formed (i) to prevent the decedent from taking imprudent actions with respect to the property (the decedent had a paramour), and (ii) to give his children more control over the assets. The Court rejected the argument, finding that the decedent did not curtail his enjoyment of the property, since he continued to manage the trust which managed the FLP. Moreover, the Court found the decedent had “commingled” partnership and personal funds, and had “used the partnership’s checking account as his personal account.” Citing Schauerhamer, T.C. Memo. 1997-242, Judge Colvin concluded that inclusion under §2036(a) was required since the decedent’s relationship to the assets “remained the same after he transferred them.”

The Estate, in attempting to distinguish Schauerhamer, argued family members had testified that the decedent’s relationship with the transferred assets was intended to remain the same after the transfer. The Court however, rejected the distinction, remarking that “[t]he decedents in both Schauerhamer and the instant case commingled funds.” The Court also noted that the decedent was left with virtually no income or assets after the FLP transfers.

The holding in the case is not surprising; nor does it appear erroneous. The case is nevertheless of concern to estate planners since §2036(a) had not found routine application in the context of FLPs; the fiduciary duty of the Manager was thought to preclude its relevance. Here §2036(a) was applied based on an implied agreement at variance with the formalities of the legal transfers. In combating what it perceives as abusive FLPs, the IRS strategy has been to argue that the transactions lacked substance, or that inclusion should result under §2704(b). §2036(a) represents a new potent potential weapon. One almost regrets the poor planning and execution which caused this case to be decided.

In any event, if §2036(a) is to be avoided, the fiduciary duties of the managing member of the FLP must be taken seriously. A mere recital in the operating agreement of the Manager’s fiduciary duties may be insufficient. Implied agreements are difficult to disprove; to defeat the assertion the taxpayer should be armed with demonstrable facts negating its existence during the lifetime of the agreement.

Retaining sufficient assets so as to avoid dependence on the FLP for income would undermine the argument that the transferor was intended to continue to benefit from the assets or income of the FLP. Frequent (and substantial) distributions to family members would also be probative of the absence of an implied agreement. If the parent continues to live in the residence, a lease agreement with monthly payments to the FLP is crucial. Finally, and perhaps most importantly, partnership and personal funds must never be commingled.